China’s choice: Covid zero or Xi’s three red lines

You can't have your cake and eat it too. It's an expression that warns people not to want things that are inherently incompatible. China would do well to heed this wisdom. 

In recent years, the government launched quite a few ambitious top policies that would fundamentally alter its economy. At the top of mind was its response to the Covid-19 pandemic. While the world is living with the virus, China still has no tolerance for outbreaks.

Another seismic change was Beijing's approach to real estate, where investment in the sector alone accounted for more than 10% of China's gross domestic product. To realize President Xi Jinping's mantra that "housing is to be lived in, not speculated on," officials in August 2020 drew the so-called "three red lines," or accounting measures meant to rein in developers' debt. It followed with another regulation a few months later capping bank lending to the industry. 

On its own, each policy has its logic. But taken together, especially in the face of Covid's highly contagious omicron variant, the goals not only conflict with each other but threaten to toss the economy into its worst state since the Cultural Revolution. Xi will have to choose: either Covid-zero or the three red lines, but not both. 

The tension is bubbling up in unexpected places. In recent days, homebuyers in China's smaller cities have refused to pay mortgages for flats that their financially distressed developers can no longer deliver. The government is now weighing a grace period to appease the angry consumers, while banks scramble to estimate how much capital buffer they need for loans that had been considered prime.

In any other time, consumers would swallow construction delays — after all, who wants to have bad credit, especially in a country where delinquency can get you banned from boarding a high-speed train? But extended Covid lockdowns have dented households' cash flow. These buyers are essentially paying double rent — on apartments they are living in, and the new home they can't move into — when unemployment is elevated and companies are cutting pay.

The central city of Zhengzhou — site of the world's largest iPhone assembly plant— makes an excellent example. It's the epicenter of this mortgage boycott, where homebuyers protested against 32 project delays, according to data compiled by Shanghai E-House Real Estate Research Institute. The China Real Estate Information Corp. shows more than over 25,000 units, or 29% of total flats sold last year, weren't delivered on schedule.

Zhengzhou also suffered from strict Covid restrictions. The city of 12 million went into a district-level lockdown in mid-April for 19 days, and then again into a full lockdown in early May for a week. 

It is perhaps no coincidence that Xian ranked second in these boycotts. Earlier this month, the city famous for terra cotta soldiers was shut back down after a messy and harsh monthlong lockdown in January that grabbed international headlines.

And while much of the blame can be placed on overly leveraged developers such as China Evergrande Group, the strict top-down Covid policy has choked cash flows, turning even good companies into bad ones. After all, who can sell apartments when people are forced to stay home? 

In the first half, 34 major developers tracked by Barclays Plc saw their sales decline by 53% year-on-year. State-owned builders were not spared, either. Sales at China Resources Land Ltd. and China Overseas Land & Investment Ltd. fell by 27% and 34% respectively.

Listed developers will report their first-half earnings in August, and we already know the picture won't be pretty. The three red lines dictate how much debt a builder can accrue, and one of the metrics is its cash ratio, or whether it has enough to pay short-term debt. The debts are still there, but the money pile has shrunk considerably. There's been little income this year.

With risk aversion gripping lenders, passing all three lines has become the minimum threshold that allows builders to refinance debt. In theory, those who breach one line are still allowed 10% annual growth in debt. The reality is much different. For instance, Country Garden Holdings Co., the nation's largest builder by sales, faces such a breach. It saw a contraction in debt for the year ending June 2021, data compiled by Bloomberg Intelligence's Kristy Hung and Lisa Zhou show.

The three red lines policy classifies builders into green, yellow, orange and red zones. But with Covid-zero eroding everyone's cash flow, there are now effectively only two zones — green (maybe) and red. This housing policy has become too tight.

To be sure, there are merits to both strategies. To date, China has reported fewer than 1 million Covid cases; there are no worries about long Covid, which affects nearly one in five Americans who caught the virus. Reining in real estate is also sensible. Affordability has become an issue in large cities, while housing-related borrowing can lead to systemic financial risks. Banks alone are estimated to have 62.3 trillion yuan ($9.2 trillion) exposure, or roughly half of China's GDP. However, both policies are so ambitious and disruptive that they should not be implemented side-by-side. 

In the past, the Chinese government showed an uncanny ability to self-correct. Is it still able to accept and repair errors or are we in the let-them-eat-cake era?

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron's. She is a CFA charterholder. @shuli_ren

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.